What is an Absolute Rate and Why Does it Matter?

by Investing School on May 23, 2011

The technical definition of absolute rate, as offered by an online investment information site, is “the fixed portion in interest-rate swaps reported as a set percentage without the reference rate’s premium or discount.” Frankly, it is unlikely that that will mean much to your average new investor. Fortunately, there are simpler ways to describe this term and understand what it means to you.

An interest rate swap is an agreement between two entities to trade or “swap” the interest payments assessed upon a particular loan. For example, one company may opt to swap their fixed rate loan with another company which has a floating rate. They do so in order to minimize the risk that might result from interest rate fluctuations.

The absolute rate is not expressed as either a premium or a discount; rather, it is a fixed percentage attached to a reference rate. The reference rate is the moving rate upon which an interest rate depends, such as the prime rate or LIBOR. The absolute rate is determined by a formula that takes into account the fixed portion of the rate swap, the maturity rate and the maturity date of the swap.

One common item determined by reference rates are adjustable ratemortgages. In these cases the interest rate offered the borrower will be the reference rate, usually the prime rate, plus the spread, which is a fixed amount. As the prime rate changes so do the interest rates charged on the mortgage.

Without knowing the absolute rate when you are involved in a swap you have no basis upon which to make your decisions.

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